Managing the Five Big Types of Investing Risk

My article in this month’s AAII Journal about portfolio rebalancing drew a few comments and emails about whether it makes sense to use rebalancing as a strategy. The argument against it is that you would incur higher long-term returns by not rebalancing. Strategies intended to reduce the level of price volatility will lower returns over the long term relative to strategies that don’t seek to limit it. The two represent a trade-off: To maximize long-term returns, an investor has to be willing to incur a higher level of volatility and the potential emotional reactions that come with it. If reducing the relative level of volatility in some manner is important, then an investor has to be willing to accept the possibility of potentially lower long-term returns.

Price volatility is what many people think of when it comes to discussions of risk and investing. There are, arguably, five big types of risk investors should focus on instead. I discuss each this week and suggest ways to limit their impact.

1. Systematic Risk—Macro in nature, it is the risk incurred by simply investing in the market. Shifts in sentiment, economic trends, monetary policy, political events, wars, broad bubbles and financial crises are all types of systematic risk. The second you invest money, you become exposed to systematic risk. You can reduce its impact by diversifying across asset classes and geography.

2. Unsystematic Risk—These are risks related to what you choose to invest in. The problems with Boeing’s 737 Max 8 jets and Tesla founder Elon Musk’s ongoing back and forth with the U.S. Securities and Exchange Commission (SEC) over his tweets are good examples of unsystematic risk. (Musk’s actions are also a good example of key person risk, which contributes to unsystematic risk.) On the bond side, it can be a change (real or perceived) in an issuer’s credit quality. The choice of portfolio strategy is also a type of unsystematic risk, especially if one purposely chooses to deviate from a market portfolio. Diversifying across securities and funds—and even strategies—reduces unsystematic risk. If you want to beat the market, you have to be willing to endure unsystematic risk.

3. Longevity Risk—The chance of outliving your savings. Very closely related is shortfall risk. Lacking enough money to pay for a child’s college expenses is a shortfall; running out of savings at age 90 is longevity risk. In both cases, they occur from a combination of not saving enough, not realizing a high enough return on your portfolio and inflation. Inflation reduces your purchasing power, meaning your ability to buy goods and services with the dollars you have. Though investing risk is often framed in terms of price and return volatility, outliving savings is the far bigger threat for most people. You can limit it by being more willing to accept price volatility in exchange for higher returns during your wealth accumulation (aka working) years, saving more and being disciplined.

4. Behavioral Risk—The loss of potential return due to your own mistakes and cognitive biases. It comes from a variety of aspects: overconfidence in your abilities, assuming the current conditions are predictive of the future, being too fearful of short-term losses, etc. Behavioral risks are especially dangerous because people typically don’t realize they’re making mistakes at the time they’re acting; rather the human mind attempts to rationalize its behavior. Three ways to limit behavioral risk is to have a well-thought-out written plan, look at your portfolio less frequently and keep a log of your decisions. Discipline beats higher levels of intelligence and skill when it comes to doing well at investing.

5. Liquidity Risk—Sooner or later, you will need to take money out of your portfolio. Liquidity is your ability to do so quickly with very limited price disruption and transaction costs. FDIC-insured savings accounts, money market funds and Treasury bills generally have no liquidity risk. An index fund tracking the S&P 500 has limited liquidity risk as well since you can sell it at prevailing market prices and withdraw your money in a few days. Annuity contracts can be costly to pull out of. Real estate investments take time to sell, have higher transaction costs and lack frequently updated prices. Investments in non-publicly traded securities and businesses have high levels of liquidity risk. Penny stocks can also be very hard to get out of at desired prices. Maintaining a balance in cash and cash-equivalents (CDs, money market funds, etc.) gives you easy access to cash; plus, they allow you to postpone pulling out of more volatile or less liquid investments during down markets.